Theodoros Papaspyrou *
This article examines certain aspects of the currency turmoil in Europe during the past one and a half year, in the light of the drive towards EMU and against the background of developments in financial markets and in international capital flows. As the details of this turmoil are given elsewhere in this volume they will not be repeated here.
On the basis of this review, a number of conclusions are drawn and policy
implications are explored. The examination of implications is limited to
analytic issues; operational or institutional aspects of the existing monetary
arrangements are not examined.
II. Rationale of capital liberalisation and policy implications
The reasons for the accelerated process of capital liberalisation in the Community in recent years should be sought in the importance of these developments for the achievement of key Community objectives:
(i) the creation of an unified European financial area as part of the Single market and
(ii) progress in the implementation of EMU.
The first of the above objectives is mainly associated with the microeconomic dimension of capital movements and their contribution to an increased welfare by facilitating market integration and a more efficient allocation of resources. Free mobility of capital and financial integration are also prerequisites for progress towards EMU: monetary integration requires an effective development of financial and monetary instruments necessary for the implementation of a coordinated and, finally, single monetary policy
On the other hand, capital movements impose certain constraints on economic policy. As a well known proposition in international macroeconomics, which has also been corroborated in practice, states there is an inherent incompatibity between free capital mobility, fixed exchange rates and independent monetary policies.
The question therefore arises, in view of the recent currency crisis, whether this fundamental issue was taken into account in the design of the programme of capital liberalisation and monetary integration in the Community.
The answer to this question is positive: the drafters of the Treaty of Rome, as modified by the Single Act, and of the Treaty on European Union were aware of this constraint and the risks involved if incompatible policies were pursued. It is precisely for this reason that complete capital liberalisation was associated with requirements for higher degree of monetary co-ordination during the transition to EMU and a fixed timetable for a single currency.
The recent experience showed, however, that there was probably an underestimation of the risks involved in the transition period, especially in the presence of external shocks, unequal economic structure and financial conditions and not synchronised cyclical movements. Moreover, the globalisation of financial markets and the easy shift of huge capital flows across countries and currencies complicated the management of the existing system, the ERM, compared to a situation of relatively segmented national financial markets and less than full mobility of capital.
The presence of external shocks, and the differentiated
structural and cyclical conditions reflect, to a significant extent, the
fact that a satisfactory degree of co-ordination of monetary policies was
not achieved within the ERM. Furthermore, the same factors make very probable
that co-ordination of monetary policies is a necessary but not a sufficient
condition to ensure a safe passage through the transition period. A more
comprehensive approach would be necessary, centred on the requirement of
sustainability of policies and due consideration of the operation of the
financial markets. The main ingredients of such an approach are outlined
below, after a short review of recent developments and trends in financial
markets and international capital flows.
III. Recent developments in financial markets and international capital flows
The main feature of the new financial environment in recent years is the globalisation of financial markets, itself the result of the enormous advances in telecommunications and in information technology. These developments, combined with the dematerialization of financial assets, reduced the cost, improved the dissemination of information about investment opportunities and led to an increasing internationalisation of portfolios.
The other major contribution to this internationalization was the generalised perception that capital controls are - at least for developed, industrial countries - counterproductive. Moreover, the interaction between deregulation and technological developments gave rise to the phenomenon of financial innovation, witness of which is the impressive array of available financial instruments and techniques and the growth of "derivatives" markets.
A measure of the recent developments in international
financial transactions is given by the volumes involved in international
capital flows, turnover in foreign exchange markets and the increasing
share of institutional investors in international flows of funds. For example,
the worldwide volume of foreign exchange transactions is estimated to have
tripled in the last six years, reaching an estimated US $ 1000 billion
a day. Also, a measure of the steep rise in the flows of portfolio capital
in the Community, in recent years, is given by the fact that in 1992 inflows
in the Community accounted for 64% of total inflows in industrial countries.
IV. Lessons from the currency crisis and implications for policy
The currency turmoil within the ERM brought into focus the central role of expectations, under conditions of free capital mobility, in the financial and foreign exchange markets. Under normal market conditions and stable expectations small changes in interest rates can easily generate big enough capital flows able to finance current account deficits, recycle surpluses and support a currency parity. However, adverse market expectations can provoke destabilizing capital flows and pressure on the exchange rates which can only temporarily be contained by central banks' intervention in the forex markets or by interest rate changes, unless such market expectations are reversed.
The events over the past one and a half year in the foreign exchange markets lead to the conclusion that market participants form their expectations about the sustainability of currency parities on the basis of a wider range of elements than relative price performance or the external balance. The concept of internal balance (broadly defined as corresponding to high employment and high degree of use of productive capacity) seems to be also relevant for the determination of the sustainability of a currrency parity and, by consequence, of the policies pursued in order to support such a parity
Also, external shocks are expected to have a varying impact on the sustainability of policies, as perceived by market participants, depending on the initial conditions regarding key variables, such as the indebtedness of the public and private sectors, labour market situation, trade openness etc. Moreover, non-economic, factors such as consensus or diverging views among political parties, or views of influential interest groups, on the basic economic policy options may have an impact on market expectations. Thus the element of political uncertainty has gained an increased importance for the stability of exchange rate arrangements
This analysis may help to explain why an increase in interest rates may not be adequate to stabilize the exchange rate. On the contrary, it may even have the opposite effect if it is seen as exacerbating internal inbalances, while a fall in interest rates may strengthen a currency parity. This last situation may arguably be the case as far as the French franc is concerned: the widening of the currency bands, last August, and the fall in franc interest rates led to a strengthening of the franc by the end of the year, after a temporary weakness. Obviously the financial markets were of the opinion that this new combination of exchange rates and interest rates suits better the needs of the French economy.
The notion of sustainabity of policies as assessed by financial markets deserves some clarification. Exchange market pressure on a specific currency does not necessarily imply that the policies of the country concerned are unsustainable or as evidence of unsound fundamentals. It may simply indicate that, in view of the slowness of the adjustment or/and the uncertainty concerning the continuation of a policy course, a "forced adjustment" through the foreign exchange market would be preferable as being less risky.
It is evident from the above that monetary policy alone cannot ensure the sustainability of a currency parity if such a policy is not part of a coherent economic policy package. It is certainly true that the use of monetary policy instruments for the defense of the exchange rate (and the external policy targets in general) is based on solid academic theory and has also practical relevance. This should not, however, lead us to the conclusion that such an instrument would be a substitute for a coherent set of economic, monetary and financial policies. Market reaction reminded us of this reality.
The existing differences in labour market conditions, public debt, indebtedness of the corporate and households sectors etc. pose also the problem of the appropriate content of the coordination of monetary policies. It is evident from the experience of the past year that what is needed is not just a coordination of monetary policies but coordination at the right level (in a certain sense during the recent past there was not absence of coordination but an attempt of coordination at the wrong level: an attempt by ERM participants to shadow DM interest rates).
It emerges from the above that financial markets' reaction is taken, explicitly or implicitly, as the ultimate verdict on the sustainability, or absence thereof, of economic and monetary policies. This situation becomes even more unconfortable if one bears in mind that it is not certain that financial markets are infallible in their judgement or that exchange rates freely determined by market forces ensure optimal trade and investment decisions The overvaluation of the dollar during the first half of the eighties and its subsequent sharp fall is often cited as the most notable example of exchange rate misalignment.
The concerns often evoked in connection with the operation of financial markets arise from:
- the overreaction of financial markets, notably forex markets, to existing or anticipated economic or other difficulties
- the alleged inherent instability of financial markets
- developments in assets' prices (share prices, prices of real estate etc) can have significant impact on the economy if such price movements are reversed.
These concerns should be nevertheless qualified: the principal source of foreign exchange market instability are incoherent economic and financial policies. There is no conclusive evidence that financial markets themselves have been the source of instability, although the way they react tends to amplify disturbances originating elsewhere in the economic system.
There is, undoubtedly, ample scope for analysis and action on the part of the authorities concerning the operation of the financial markets and their interaction with the real economy. This interaction justifies the close monitoring of developments in financial markets and in the prices of financial assets. Such supervision may lead, if necessary, to measures aimed at strengthening the transparency and systemic stability of financial markets. This would allow the early detection of developments which may have detrimental effects on the economy. An often cited example of financial markets where the need for transparency is evident is that of the derivatives markets.
If the view according to which financial markets are inherently unstable is true, then the competent authorities must examine ways to contain such instability.
This brings us to the issue of a potential trade-off between efficiency and stability in financial markets: should we sacrifice some efficiency for a higher valued stability? In principle the society may take measures in order to limit an activity considered as harmful. In practice the difficulties of such an approach are formidable. Our incomplete knowledge of the operation and the dynamics of the financial markets should make us cautious on taking measures which might have perverse effects or/and been ineffective.
Having accepted, intellectually and legally, the merits
of free markets, any restrictive measures must be fully justified and have
the least adverse side effects. In this respect, the letter and the spirit
of the Treaty provisions should be respected. It deserves to be recalled
that according to the Treaty on European Union all restrictions on the
movement of capital are abolished: the only possibility left is safeguard
measures, of a short duration and under exceptional circumstances, concerning
capital movements vis-à-vis third countries.
V. Concluding remarks
It might sound paradoxical in view of the recent currency crisis, but there are reasons to believe that the situation and prospects in the financial and monetary field might be better than many observers and commentators seem to believe. This view is based on the following factors:
(i) The EMU project corresponds, in the perception of the markets (as evidenced in market surveys) to the long-term interest of the Union members. The ratification of the Treaty on EU provides the missing element which is necessary for the stabilisation of expectations. This uncertainty was one of the main factors behind the currency crisis of the past year.
(ii) The institutional solutions and the instruments provided in the Treaty concerning economic policy surveillance are expected to contribute to the implementation of sound policies and to the adoption of early corrective measures if this proves necessary.
(iii) The recent currency crisis supplied valuable lessons which must be taken into account for the design of economic and monetary policies in the future.
Although the focus should certainly be on the pursuit
of sound monetary and budgetary policies and the appropriate policy mix,
the overall situation of the economy, proxies by the term "internal balance"
should be also taken into account. In addition, particular attention should
be paid to the operation and dynamics of financial markets and the interaction
of financial developments with the real economy.
BIS, "Annual report", 1993.
Lamfalussy A. "International financial integration and macroeconomic policies". Address at S.W.I.F.T. International banking conference in Geneva, September 1993.
Padoa Schioppa T. "Financial and Monetary Integration
in Europe: 1990, 1992 and Beyond", Group of Thirty, Occasional Papers,